The stock market’s next step could tip the balance toward bears — or bulls

The U.S. stock market’s bulls and bears have for months been an arm-wrestling match with no end in sight. However, whichever side “wins” could dictate the tone on Wall Street for months.

For all the back and forth seen on Wall Street thus far this year, there has been one primary story that explains most of 2018’s trading activity. There are a number of negatives in the market—among them the specter of a trade war, less accommodative central banks, and the fact that gains have come on the back of a few big stocks, as opposed to being broad-based—that have put a ceiling on prices. This ceiling is represented by the record highs the Dow Jones Industrial Average
DJIA, +0.45%
and the S&P 500 index
SPX, +0.64%
hit in late January.

At the same time, there are numerous positives in the market, including strong economic data, earnings growth, and the growing impact of 2017’s tax bill. These have served to put a floor under equity prices, the 2018 low that was put in shortly after the most recent record.

The result of this is a market that has been stubbornly rangebound since February, with both the Dow and the S&P unable to break out of this roughly 10%-wide spread of prices. Both have been in a correction, defined as a 10% drop without a full recovery from that low, since February, their longest stretch since the financial crisis.

In a sign of how uncertain investors are about the current environment, the AAII Sentiment Survey shows that 32.9% of investors describe themselves as neutral on the market, meaning they expect prices will remain roughly the same over the coming six months. This is above the long-term average of 31%; neutral sentiment has been above the historical average for 20 straight weeks.

Eventually, however, either the bull case or the bear case will dominate, and indexes will move out of their range. Whichever side “wins” remains to be seen, but analysts say that the first side of the range to be breached could set the tone going forward. In other words, if stocks put in a new high for the year, expect more records to follow. If they put in a new low, don’t be surprised if the selling accelerates.

“The market has been balancing the positive and negative sides of the equation, but either side could easily overwhelm the other,” said David Carter, who oversees about $2 billion in assets as the chief investment officer at Lenox Wealth Advisors.

“If the issue of a trade war goes away, our fundamentals are strong enough to support our going to new highs and beyond. But if the trade skirmish escalates into a full-blown trade war, that will swamp the fundamentals and equity markets will really suffer. Not only would we put in new lows, but it’s really unclear how far we could fall.”

According to UBS, the S&P 500 could fall 11% if trade tensions escalate, which would put in a new low for the year. If the issue becomes a full trade war, the S&P could drop 21%, enough to put it in bear-market territory.

Courtesy UBS

At current levels, the Dow is 6.6% below its record, and 5.8% above its closing low of the year. The S&P is 2.9% beneath its record and 8.2% above its closing low.

Recent action has trended higher, with stocks on track for their fifth rise of the past six sessions on Thursday. Equities have also been improving on the basis of technical analysis. According to StockCharts, 61.8% of S&P 500 components are above their 200-day moving average, a closely watch level for long-term momentum trends. While this is below the 80% rate hit in late January, as well as the 67.67% average over the past 200 days, it is up from the roughly 55% rate in late June.

Just 61% of S&P stocks are below their 50-day, used as a proxy for shorter-term momentum trends. This is almost the exact average ratio over both the past 50 trading days and the past 200 days.

“The fact that we’ve been rangebound makes sense. The market’s general momentum and sentiment are still positive, and we’ve yet to see the full effects of the tax-cut legislation. However, if we haven’t seen the impact of that show up, we certainly haven’t seen the impact of what the trade issue could mean if it escalates,” said Steve Sosnick, chief options strategist at Interactive Brokers Group.

Sosnick said he wasn’t just looking to see whether the market would break out of its range to determine the narrative over the subsequent months, but why it does.

“The fact that the S&P hits a certain number wouldn’t change the outlook. A slow grind higher or lower wouldn’t mean that a material change in the environment. It’s the how and the why that changes the narrative.”

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